Business finance ch 4 the financial environment

Constructing the yield curve: InflationSuppose, that inflation is expected to be 5% next year, 6% the following year, and 8% thereafter.. Constructing the yield curve: Inflation Step 2

CHAPTER 4

The Financial Environment:

Markets, Institutions, and Interest

wanting to borrow funds are

brought together with those having

a surplus of funds

Types of financial markets

 Physical assets vs Financial assets

 Money vs Capital

 Primary vs Secondary

 Spot vs Futures

 Public vs Private

How is capital transferred

between savers and borrowers?

 Direct transfers

 Investment banking house

 Financial intermediaries

Types of financial

intermediaries

 Commercial banks

 Savings and loan associations

 Mutual savings banks

 Credit unions

 Pension funds

 Life insurance companies

 Mutual funds

Physical location stock

The cost of money

 The price, or cost, of debt capital

is the interest rate

 The price, or cost, of equity

capital is the required return

The required return investors

expect is composed of

compensation in the form of

dividends and capital gains

What four factors affect the cost of money?

 Production opportunities

 Time preferences for consumption

 Risk

 Expected inflation

“Nominal” vs “Real” rates

of interest Like a T-bill rate, if there was no inflation Typically ranges

from 1% to 4% per year.

Treasury securities.

Determinants of interest rates

Premiums added to k* for

different types of debt

Yield curve and the term

structure of interest rates

 The yield curve is a

graph of the term

Constructing the yield curve: Inflation

 Step 1 – Find the average expected

inflation rate over years 1 to n:

n

INFL IP

n

1 t

t n







Constructing the yield curve: Inflation

Suppose, that inflation is expected to be 5% next year, 6% the following year, and 8% thereafter.

IP1 = 5% / 1 = 5.00%

IP10= [5% + 6% + 8%(8)] / 10 = 7.50%

IP20= [5% + 6% + 8%(18)] / 20 = 7.75% Must earn these IPs to break even vs

inflation; these IPs would permit you to

earn k* (before taxes).

Constructing the yield curve: Inflation

 Step 2 – Find the appropriate

maturity risk premium (MRP) For

this example, the following equation will be used find a security’s

appropriate maturity risk premium.

)1-

t (0.1%

MRPt 

Constructing the yield curve: Maturity Risk

Using the given equation:

MRP1 = 0.1% x (1-1) = 0.0%

MRP10 = 0.1% x (10-1) = 0.9%MRP20 = 0.1% x (20-1) = 1.9%Notice that since the equation is

linear, the maturity risk premium is increasing in the time to maturity,

as it should be

Add the IPs and MRPs to k* to

find the appropriate nominal

Hypothetical yield curve

 An upward sloping yield curve.

 Upward slope due

to an increase in expected

inflation and increasing maturity risk premium.

Real risk-free rate

What is the relationship between

the Treasury yield curve and the

yield curves for corporate issues?

 Corporate yield curves are higher than that of Treasury securities,

though not necessarily parallel to the Treasury curve

 The spread between corporate and Treasury yield curves widens as

the corporate bond rating

decreases

Illustrating the relationship

between corporate and Treasury yield curves

Pure Expectations

Hypothesis

 The PEH contends that the shape of the yield curve depends on investor’s expectations about future interest

rates.

 If interest rates are expected to

increase, L-T rates will be higher than

S-T rates, and vice-versa Thus, the

yield curve can slope up, down, or

even bow.

Assumptions of the PEH

 Assumes that the maturity risk

premium for Treasury securities is zero

 Long-term rates are an average of current and future short-term

rates

 If PEH is correct, you can use the yield curve to “back out” expected future interest rates

One-year forward rate

6.2% = (6.0% + x%) / 2 12.4% = 6.0% + x%

PEH says that one-year securities will yield 6.4%, one year from now.

Three-year security, two years from now

6.5% = [2(6.2%) + 3(x%) / 5 32.5% = 12.4% + 3(x%)

6.7% = x%

PEH says that one-year securities will yield

Conclusions about PEH

and hence the PEH is incorrect.

view that lenders prefer S-T

securities, and view L-T securities as riskier.

them to hold L-T securities (i.e., MRP

Other factors that influence

interest rate levels

 Federal reserve policy

 Federal budget surplus or deficit

 Level of business activity

 International factors

Risks associated with investing overseas

 Exchange rate risk – If an investment is denominated

in a currency other than U.S dollars, the

investment’s value will depend on what happens to exchange rates.

 Country risk – Arises from investing or doing business

in a particular country and depends on the country’s economic, political, and

Factors that cause exchange